Firms With Highest CEO Pay Ratios Underperform With More Risk

A new study found that increasing CEO pay improves performance and reduces risk, but only up to a certain point, and then it actually becomes harmful

In September 2013, the SEC voted to require most companies to start disclosing their CEO pay ratio – the amount the CEO gets paid relative to the average employee. The rule didn’t have a specific policy objective, but greater transparency was in-line with other shareholder friendly measures such as Say on Pay and advocates thought it might put some pressure on excessive compensation packages. It turns out that most CEOs don’t get such extravagant packages, but the ones who do tend to underperform while taking on excess risk.

“Firms with extreme high pay ratios are riskier, perform worse, and experience greater dissent on shareholder “say on pay” (SOP) proposals. However, there is an overall concave (convex) relation between the pay ratio and future operating performance (risk and SOP voting dissent),” write accounting professors Steven Crawford (University of Houston), Karen Nelson, and Brian Rountree (both at Rice University) in their paper The CEO-Employee Pay Ratio.

CEO pay ratios grow rapidly in the top decile

The study, based on more than 10,000 observations in the banking sector between 1995 and 2012, found that the mean CEO pay ratio is 16.58 and the median is 8.38, and the 90th percentile is still only 32.86, but the number ramps up rapidly once you’re in the top decile. The CEO pay ratio for the S&P 500 is currently 204 – 1 and nearly 500 – 1 for the top 100 companies, maxing out at 821.17 – 1 according to the report. So while the reported extremes in CEO compensation certainly exist, they aren’t the norm.

That still leaves the question of whether companies should pay more to get the best CEOs. Academics are divided both on what you would expect (some argue that bug pay bumps drive internal competition and firm performance, others expect it to alienate workers and hurt performance) and what actually happens. Crawford, Nelson, and Rountree say that’s because the relationship is non-linear – at some point higher salaries aren’t just give you diminishing returns, they are actively harmful.

CEO pay ratios past 18 – 1 are typically counterproductive

Up to a point, they find that increasing the CEO pay ratio gets you better firm performance, lower risk, and less grief from shareholders, but all three measures bottom out and start rising again if the pay ratio gets too high. That happens at different points, ranging between 8 – 1 and 18 – 1, but the 32x multiple you get at the 90th percentile is already too high on all accounts. They warn that this relationship isn’t statistically significant immediately after the financial crisis, but that seems reasonable as other factors would have clouded out the impact of executive pay during all the chaos.

The study also looked at CEO pay slice, the ratio of CEO pay to the top five executives, and found that you get a similar non-linear relationship (more is better, but only up to a point) which is incremental to the CEO pay ratio. In other words, investors really need both pieces of information if they’re going to predict how compensation will affect future performance.

It’s easy to find anecdotes that match their findings, like former J.C. Penney CEO Ron Johnson who reportedly had a four-digit CEO pay ratio while driving the company into the ground. But the finding also makes sense intuitively. Up to a point, companies who are willing to pay more get better CEOs, and shareholders don’t really object. But if the pay gets too high then the only people who can really justify such a big paycheck are the ones who have taken outsized risks that paid off – but that’s no reason to think the next one will as well. And you would expect shareholder friction, in the form of say-on-pay votes that go against management, to follow since no one likes to pay more for less.